The Hard Factors Behind the Run-Up in Oil Prices
The factors which have contributed to the historic rise in the price of oil have become topics of significant debate. The steady decline of the U.S. dollar against the major world currencies and speculative behavior are cited as some of the primary causes. Oil ministers at certain of the major oil producing nations have publicly stated there is no fundamental reason for the run-up and that current supplies are sufficient, supporting the view that “soft” factors are largely to blame. Reports in the media have highlighted the availability of billions of barrels of oil reserves adjacent to the coast lines of the U.S., as well as from tar sands and oil shale in North America, indicating that additional supplies are within reach. However, a closer look at the dynamics of the oil market indicates that the “hard” factors of supply and demand appear to be major contributing factors to the record run-up in prices. Namely, there is mounting evidence that unabated demand growth from emerging economies will cause total world demand to break through the feasible limits of production capacity.
Mounting Supply Concerns
Tensions in the Middle East, attacks on oil fields, and threatened or actual labor strike action are factors that have caused supply concerns in the world oil markets. However, the most problematic issue that is igniting supply fears among energy analysts is the declining production rates of the world’s existing oil fields. It is well established that after an oil field is fully ramped up, the flow of oil from that field will gradually decline as the well ages and its reserves become depleted. The problem facing the oil industry is that most of the world’s largest producing oil fields are on average more than 20 years old and well into the decline phase of production.
Various energy research firms estimate that as a whole the world’s existing oil fields are suffering at least a 4% rate of decrease in annual production. Since world oil production approximates 80 million barrels per day (bpd), the industry needs to find over 3 million bpd of new capacity every year just to break-even before meeting incremental demand. As shown in Exhibit 1, much of this gap has been met over the past several years by eating into the cushion of known OPEC surplus production capacity, which averaged 4.3 million bpd from 1998 through 2002 but only 1.6 million bpd from 2003 through 2007.
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Exhibit 1: OPEC Surplus Production Capacity & World Production/Consumption 1 |
There is limited evidence of additional near-term supply sources that will produce meaningful levels of new production output. Saudi Arabia is one of the noteworthy examples where incremental production may be achieved, though debate exists around the degree to which this can be achieved. Otherwise, we will need to see changes in the political arena, e.g., exploration and development off of the U.S. coast lines. There are also close substitutes such as tar sands but these only produce a little over 1 million bpd today and industry analysts expect this to reach only 3 to 4 million bpd by 2025. Oil shale is another opportunity but current production levels are miniscule and this process faces significant technological hurdles because the shale needs to be heated in order to extract the oil. Biofuels are a substitute for petroleum end-products but a mounting global food crisis is likely to see limited incremental supply until they are produced from sources that do not touch the food supply chain, e.g., cellulosic ethanol. Based on the foregoing, the oil industry has had to progressively rely on smaller oil discoveries or new alternatives, and notably by tapping into surplus OPEC production capacity. It appears that a relatively limited amount of new “mainstream” capacity will be coming online in the short term to plug the gap caused by oil field depletion let alone to meet incremental demand.
Unabated Demand Growth
The strongest period of economic growth in the developing world since the 1960’s brought on from continued globalization of the world economy has dramatically increased worldwide oil consumption over the past decade. Countries which are large producers of oil also showed strong demand growth owing directly to the rise in oil prices, which has had the knock-on effect of reducing oil exports to countries that are net importers. Exhibit 2 illustrates the percentage rise in worldwide oil consumption since 1998 broken down by OECD countries and non-OECD countries. (Note: OECD countries are used as a baseline category since this is how data is commonly reported by the world energy agencies; see Footnote 2 for list of member nations.) The troubling factor is that oil demand increased substantially at the same time that prices increased by over 450% to an average price of about $70 per bbl in 2007.
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Exhibit 2: Percentage Increase in Oil Consumption & Oil Price from 1998 1 |
Over the past several years the level of demand in the OECD economies has waned because these economies as a whole are more developed and thus less resource intensive, have a large base of discretionary demand which is more price elastic by its nature, and have had slower economic growth than many of the larger emerging economies. Conversely, in the non-OECD countries the growth in oil consumption has continued unabated because these economies have had relatively higher growth rates and they are generally more resource-intensive in nature. Moreover, their rising “middle classes” have led to sharply increased usage of petroleum products at the consumer level owing to demand for motor vehicles and the like.
The fact that the U.S. has less than 5% of the world population but nearly 25% of the global demand for oil is a calculus that is undoubtedly fueling fears of unsustainable demand growth as the economies of the world’s largest population centers continue to rapidly grow. This fear is captured in Exhibit 3 by illustrating world demand for oil if demand grew to per capita levels of OECD nations excluding the U.S. or per capital levels of the U.S. Under those scenarios global consumption would accelerate from 1 billion barrels of oil every 12 days to 1 billion barrels every 5 days or 2 days respectively. While these may be viewed as highly improbable scenarios, the combined populations of China and India alone are equal to one-third of the world total and these nations have been experiencing strong economic growth for many years; moreover, the illustration assumes no further growth in the world population from 2007 levels.
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Exhibit 3: Actual & “Potential” Oil Demand Based on 2007 Population Levels 1 |
The factors which are likely to be the leading drivers of oil prices for the foreseeable future are the state of the world economy, political tensions in the Middle East, and the evidence of demand destruction from the more recent price increases in oil. The last of these factors is most critical longer term as many energy analysts believe that global production either has peaked or will peak in the near term, due to declining production rates as previously discussed. On the demand side, consumption showed little sign of abatement even as oil prices increased by over 450% from 1998 to 2007. The more recent price rises have likely been fueled in part by the continued rise in global demand even as oil reached an average price of about $70 per barrel in 2007.
A key factor contributing to price volatility has been that information on the energy markets is opaque at best and lagged in nature for political reasons and otherwise. The data on spare production capacity is “unaudited” and the exact degree to which production declines are occurring is not known in many instances. Moreover, the demand data is sufficiently lagged such that the markets do not know the degree of demand destruction which is occurring as oil reaches ever-higher prices. As such, we are likely to see continued volatility in oil prices given the limited current data available to the market on the crucial metrics of supply and demand.
While the business of forecasting is tricky at best, a possible scenario assuming an “additional” war does not erupt in the Middle East is that price increases will abate or possibly retreat for the remainder of 2008 and early 2009 (note: oil was hovering at around $125 per bbl in late July 2008 when this article was completed), as evidence of widespread demand destruction continues to mount and the global economy faces a slowdown (which in turn should dampen the growth in oil consumption in emerging economies). Thereafter, depending on the extent of the global economic slowdown and the ability (or lack thereof) of Saudi Arabia to ramp up incremental production, oil prices will likely continue their upward march to progressively higher plateaus as new thresholds of price elasticity are broken. Later, we are likely to see an ultimate decline in oil prices as the world economy, and in particular the transportation sector which drives a majority of the demand for oil, makes a significant transition to new energy sources. This transition may be a difficult one as rising energy prices could lead to escalating global inflation and/or become a significant drag on globalization and economic growth.
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